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Wednesday, December 26, 2012

Germany: the next victim of the Japanese Model as plans for austerity made

As reported by Der Spiegel, the German government is making plans to adopt austerity as it is about to fall victim of the Japanese Model for handling a bank solvency led financial crisis.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.

What this means in practical terms is that rather than banks recognizing the losses on the excess debt in the financial system, the burden of the excess debt is placed on the real economy. This diverts capital that is needed for growth and reinvestment to debt service and shrinks the real economy.

The German government has aggressively pursued implementation of the Japanese Model throughout the eurozone following the beginning of the financial crisis in 2007. It has done so to protect the German banks who hold a significant amount of this excess debt.

Unfortunately, this policy has now caught up to Germany.

Germany has an export oriented economy. With the rest of the eurozone mired in a Japan-style economic slump from the forced adoption of the Japanese Model, there is less demand for German goods. The result is a decline in the German economy.

A decline that the German government is planning on making worse by adopting austerity. By design, austerity reduces government funded demand in the economy. This should hasten the pace at which German slides into a recession.

Of course, all of this is easily avoidable by adopting the Swedish Model and requiring the banks to recognize upfront their losses on all the excess debt in the financial system.

The question that Germany's government faces is whether it should protect its citizens or continue to protect banker bonuses.

The German government and opposition are pledging higher benefits for pensioners, families and the long-term unemployed ahead of elections next year, but Finance Minister Wolfgang Schäuble is secretly planning cutbacks to prepare for a weakening economy and possible fallout from the euro crisis.

German Finance Minister Wolfgang Schäuble has an inimitable way of misleading his listeners with a torrent of obfuscating words.

This torrent of obfuscating words is a useful skill to have in politics as it allows the speaker to say something that implies support of one idea when it fact the speaker is in complete opposition to the idea.

When asked if the Greek bailout would cost more money, he responded: "Not necessarily," adding that there was merely "a greater financial requirement on the timeline."

Of course, Greece is going to require more funds. Its debt has not yet be written down to a level that it can afford.

It could soon be a similar story with yet another gem from Schäuble's repertoire of quotations. "Germany is clearly a gainer from the euro," as the minister likes to say. But if what his team has been writing over the past few weeks is true, Germans will soon find that their presumed winnings have transformed into losses.

The government in Berlin is living in a dual reality. Strategists in the center-right coaliton parties are planning to enhance benefits for families, pensioners and the long-term unemployed in a bid to woo voters in the upcoming elections.

By contrast, due to the economic slowdown, experts in Schäuble's ministry are anticipating an entirely different scenario: The next government -- no matter who will be chancellor and which parties will be in power -- won't be able to boost spending. Instead, it will have to impose rigorous spending restraint.

Austerity comes to Germany.

According to the recommendations made by Schäuble's team, in order to brace itself for the consequences of the euro crisis, Germany will have to drastically increase taxes and make painful cuts in social services over the coming years.

Why? To protect the banks and banker bonuses.

These ideas don't fit with the current political climate in Germany, which has been characterized for months by a passionate debate about how additional money could be used to combat poverty among the elderly and improve life for low-wage earners.

Schäuble nevertheless feels that his experts' forecasts are realistic. He has expressly approved their proposals and ordered them to continue to work on the cost-cutting program....

A cost cutting program that will undermine the social contract in Germany in the same way that the social contract is being undermined across the eurozone and US.

The Germans face a bitter déjà vu. It was only 10 years ago that then-Chancellor Gerhard Schröder of the center-left Social Democrats (SPD) and his conservative challenger Edmund Stoiber fought an election campaign that was primarily focused on social justice. After Schröder's victory, it became clear that Germany was strapped for cash.

Subsequently, the chancellor introduced his radical -- and widely unpopular -- "Agenda 2010" reforms of the labor market and welfare system. This time, Schäuble's team has calculated that even deeper cuts may be needed.

No matter how deep the cuts are they will be insufficient. The real economy is unable to support all of the excess debt and continue to grow.

What the Finance Ministry officials have listed under the seemingly innocuous title "Medium-Term Budget Goals of the Federal Government" is nothing less than the most comprehensive austerity program in postwar German history. In order to avoid forcing the government to incur additional debt, the officials are scrutinizing subsidies, entitlements and welfare benefits worth tens of billions of euros.

There are also plans to raise taxes. ...

Schäuble's team wants to slash €10 billion from the federal government's contributions to the German health fund, which currently helps to stabilize premiums in the statutory health insurance system. ...

The plan also calls for state pension funds to do their part. ...

It still won't be enough and look at how massively the social contract is being rewritten rather than have the banks absorb the losses and protect the real economy as they are designed to do.

This is an important point. All of the rewriting of the social contract is being caused by government policy makers refusing to have banks perform as designed.

Banks are designed to continue operating and supporting the real economy even when they have low or negative book capital levels. Banks are able to do this because of the combination of deposit insurance and access to central bank funding.

When banks have low or negative book capital levels, through deposit insurance the taxpayers effectively become the banks' silent equity partners. It is the existence of the silent equity partners that allow the banks to continue operating.

Of course, if the banks recognize the losses on the excess debt, this means that banker cash bonuses will be reduced until such time as the banks have managed to rebuild their book capital levels.

Widows and widowers would also have to tighten their belts. Currently, the surviving spouse receives 55 percent of the deceased spouse's pension. The idea is to significantly reduce this level in the future. This initiative would annually save billions of euros for the state pension fund.

And someone in the German government thinks this is better than requiring the banks to recognize their losses. Unbelievable!

Finance Ministry officials see additional cutbacks in social services as unavoidable if the state is to spend more money in other areas, for example, on repairing roads and improving the education system. These investments would "entail stronger limitations on consumptive expenditure," as it says in the draft paper.

Of course, there would be plenty of money for both social services and repairing roads and improving the education system if needed capital were not be diverting from the real economy to support excess debt that the banks should absorb the losses on.

The proposals from Schäuble's ministry serve to tighten a regulation that has only been enshrined in the German constitution for the past few years: the so-called debt brake, which calls for the German federal government to "maintain a nearly balanced budget" starting in 2016.

The government will still be able to take out loans to some extent. In 2016, for instance, it will be allowed to borrow some €10 billion. However, Schäuble and his staff say that Germany should not completely exhaust this scope for borrowing. They want a safety buffer.

"It is absolutely necessary to maintain sufficient distance to the constitutional limit during budget planning to prepare for unexpected structural expenditure and revenue developments," it says in the paper.

The debt brake is a paid idea on par with pursuing the Japanese Model despite overwhelming evidence that it doesn't work (see Japan and its lost 2+ decades).

Since the Great Depression, government programs under the social contract have been designed to expand, think unemployment insurance payments, when economies have downturns. By definition, governments will not be able to run a nearly balanced budget during a recession as at the time the government social programs are expanding the tax revenue will drop.

The experts also note that they intend to safeguard the national budget against a series of risks.

One of the examples that they cite is "a sharp economic downturn." If the economy collapses, as it did in the wake of the financial crisis in 2009, experience has shown that public coffers come under considerable pressure. Tax revenues decline while expenditures, such as for the unemployed, massively increase.

This can have a devastating impact on state finances. Following the most recent recession, government debt soared from 65 to nearly 83 percent of gross domestic product (GDP).

Schäuble's experts say that the country cannot withstand another similar increase in public debt and conclude that it's time to take appropriate countermeasures.

To make matters worse, Finance Ministry officials say that it's also possible that Berlin will have to absorb the costs of its bank bailouts.

At the height of the financial crisis, the German government supported ailing financial institutions such as Hypo Real Estate, Commerzbank and WestLB with capital injections and guarantees amounting to nearly €180 billion. Large quantities of toxic assets were transferred to so-called "bad banks."

But it's questionable whether these banks will ever be able to completely pay back this money. If that is the case, the federal government will have to waive its claims and permanently absorb the debt.

Again, the solution lies in having the banks absorb the losses on all the bad debt.

Schäuble's team foresees the possibility of a similar development with the euro rescue.

Indeed, "irrevocable ESM payment defaults" is one of the reasons they list for their contingency plans. Behind the bureaucratic jargon lies the concern that Germany -- despite the government's solemn statements to the contrary -- will have to pay for the euro rescue.

Germany is currently supporting the European Stability Mechanism (ESM) to the tune of at least €190 billion. A portion of these guarantees and loans could actually be lost if Greece's government creditors forgive some of the country's debt. The losses to German public coffers could then easily amount to tens of billions of euros.

Again, push the losses back on to the banks that are designed to absorb it without putting the burden for paying for these losses on the taxpayers.

Consequently, Finance Ministry officials contend that the government will have to make cutbacks elsewhere in the future. Now, in a scenario that euroskeptics have long been warning about, German Chancellor Angela Merkel's government has finally admitted, for the first time, that to balance out the impact of the monetary crisis it will have to reduce expenditure for pensioners and people taking early retirement.

So pursuit of the Japanese Model and protecting bank book capital levels and banker bonuses has finally come back to haunt the German taxpayer.

The paper by the Finance Ministry officials contains a further admission. The next finance minister will have to make up for what Schäuble has failed to accomplish.

Merkel's most important minister forced half of Europe to submit to austerity measures while the Germans were spending money hand over fist at home....

Correct, Germany pursued the Japanese Model when it should have been pursuing the Swedish Model and requiring the banks to absorb their losses.

Had the German government done so, the real economy would have been protected and with it all of the social programs.

And, in keeping with his style, he is carefully preparing the Germans for hard times with his signature inscrutable Schäuble-speak: "We cannot allow ourselves to believe that the current positive situation is automatically secured for the future," he says.

He goes on to say that sound public finances are "not a notion created by stubborn finance ministers, but rather the prerequisite for prosperity and social security." In plain language: Germany is going to start subjecting itself to some iron fiscal discipline.

In short, rather than admit the mistake of pursuing the Japanese Model and adopting the Swedish Model, the German government would rather rewrite the social contract to the detriment of Germany's citizens.

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A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.